Federal Budget Update: Fiscal Austerity Is Not Bad For Growth

Note how flat spending has been since the end of the recession. Up only 3.7%! Of course, spending rose 23% during the recession, so this is only a modest payback. But it is at least a significant step in the right direction. Hard to believe that we are going to see any major spending initiatives get approved this year. Obama is proposing much more spending, but it's likely to be passed. The increase in revenues post-recession has faded, however. But from the low in revenues in late 2009, we have seen an increase of 14% despite net reductions in tax rates (e.g., the payroll tax holiday).

Federal spending has been very elevated as a % of GDP, well above its post-war average of about 19%, and federal revenues as a % of GDP have been well below its post-war average of about 17%. The increased spending mostly represents a big increase in federal transfer payments (e.g., income redistribution), while the shortfall in revenues can be traced largely to the fact that there are 5 million fewer workers today than there were prior to the recession. Also, the payroll tax "holiday" that has been in effect for over a year now, and that has reduced revenues meaningfully. Unfortunately, that type of tax cut has very little impact on growth, since most consumers view it as only temporary. Tax cuts need to be permanent and across the board to have a decent stimulative effect on growth.

We are still looking at trillion-dollar deficits for as far as the eye can see, but there has been some improvement on the margin in recent years. From a high of $1.48 trillion in early 2010, the deficit has declined by 17%.

As for this last chart, let me say at the outset that it is highly controversial. I don't want to assert here that there is any causal relation between the level of government spending and the unemployment rate. Nor do I want to assert that the official unemployment rate is an accurate reflection of the true state of the labor market. Both assertions could be debated by reasonable people. However, whatever measure of unemployment you prefer, it is nevertheless the case that there has been some improvement in recent years, at the same time as the level of government spending relative to GDP has declined.

What I do think makes sense and is important to note is that the chart shows that spending can decline relative to GDP (by growing very slowly or not at all), and that is not inconsistent with an improving and growing economy and reduced unemployment. This runs directly counter to the prevaling Keynesian wisdom, which holds that a reduction in government spending (i.e., fiscal austerity) will result in a weaker economy and must therefore be avoided. By not spending more as the economy grows, the government effectively allows the private sector to keep more of what it makes. Since the private sector spends money more efficiently (and less corruptly) than the public sector, shrinking the public sector (even just in relative terms) goes hand in hand with stronger growth. That's just plain common sense.

Can we confidently predict that more fiscal austerity would translate into stronger growth? No. But neither can we confidently predict that fiscal austerity would result in slower growth. I see this chart as supportive of the case for fiscal austerity, and destructive of the case for continued stimulus. It shows that we can cut back on the growth of spending and avoid increasing taxes without damaging the economy.